My wife and I recently sent our kiddos back to school. It is fun seeing them get older, but always tough acknowledging that we are one more summer closer to them growing up. My younger son, Tyler, is playing football this year. Practices started a few weeks ago, and I am involved in coaching his team. I played football in high school and college, so I like to think I know a little bit about the game, what it takes to be good at certain positions and how to put together an effective team. Here are some of the assumptions I formed in my time playing:

Quarterback – Has to be able to lead the offense, be focused, remember the plays, read the field, throw the ball accurately and run well

Running back – Smaller, faster members of the team; must be able to run, catch and block well

Offensive lineman – Bigger, stronger members of the team; must be able to block and move opponents at the line of scrimmage

Wide receiver/tight end – must be fast, catch well and block well

Defensive lineman – Bigger and stronger; must use quickness and variation to get through blocks

Defensive backs – Fast and agile; able to make plays on thrown balls and make second level tackles

No one player wins or loses a football game; all players must contribute by completing their individual assignments

I kept this pretty high level, but if you know football, you’re probably shaking your head in agreement with most of these thoughts.

But we had our first scrimmage this weekend and, let me say, I was wrong on a few of these premises. Very wrong. I forgot to take into account that Tyler is in second grade and that the flow, speed and capability of play of football at that age requires a different outlook. I found that quarterbacks don’t really need to throw and receivers don’t really need to catch, because at this age, completing a pass for yardage is an anomaly! The same goes for the rest of the positions. The kids that like to hit and get hit are the ones that stand out in each position.

So how does this relate to investing? Many of us have a process we undertake to determine if a fund or manager is good and the truth is, many times, that process is flawed. It is wise to have a process for performance evaluation, but it is imperative that we recognize where that process can provide inconsistent or just plain bad information. Let’s look at some of the common pitfalls.

Many individuals view past performance as a major indicator of whether or not a manager or fund can achieve similar results in the future. As you can see by the diagram below, past performance is indeed an unreliable indicator of future performance. The majority of managers in the top quartile fall to below median in the following five-year period. We have run this analysis every year for the last 10 years and it hasn’t changed meaningfully.

I understand that performance evaluation is a staple in some of your businesses, so please take time to understand the drivers of the manager’s performance. As an example, a manager who focuses on valuation (buys deep value securities) versus a manager who focuses on momentum (buys managers with growing earnings) will have different performance over similar timeframes, but that performance is no indication that one manager is better than the other. It simply means that one manager’s approach was favored during the period of evaluation.

For this reason, it is important to consider annualized and calendar year performance in any performance evaluation. Annualized performance can be skewed by one significant return experience during the time period analyzed, whereas calendar year performance may make it easier to see anomalies in the return stream and, therefore, help identify what drove those returns during that time and corresponding times. We can use that information to better understand that manager versus the market environment. This helps us choose a manager we believe will be in favor in the upcoming market environment. Now, determining what manager style could be in favor is no easy feat, but it is a much better approach than not considering it at all. We (SEI) believe in maintaining exposures to multiple managers to provide diversification of styles and reduce the need to pick which style will be in favor over the next period.

Past performance vs. peers

Another common evaluation tool is to look at how a manager or fund did against its peer group over various short and long-term periods of time. The argument around manager/fund style is just as robust versus peers as it is against benchmarks. Annualized and calendar year performance versus peers provides a more complete picture. Again, trying to determine how a manager generates return and understanding how that fits, relative to the peer group, can be helpful in evaluating their level of skill.

Aside from style, there are some other potential pitfalls to consider when completing peer evaluations. I can’t cover all of the idiosyncrasies here, but hopefully these few examples will provide some insight that can be applied to your process and help identify issues that could impact your outcomes in the future.

Inaccurate peer group – Sometimes the fund or manager just isn’t classified properly. Many times, third-party vendors use holdings-based or returns-based screens to determine where a manager/fund belongs, but these screens may miss a broader investment approach the manager employs. A perfect example of this is a manager who has the ability to invest in small-, mid- and large-cap securities, but is largely exposed to mid-cap securities at the moment. This manager would be categorized as a mid-cap manager, but the manager has no intent of being a mid-cap manager in the future.

Broad peer group classifications – Many times, a peer group will be so broad in nature that it captures funds/managers that have very different styles and throws them into the same general bucket. The intermediate bond peer group demonstrates this challenge. Fund managers with intermediate duration mandates will sometimes focus on holding government securities versus corporate securities. When looking at the intermediate peer group, one mandate may look more favorable than the other, but knowing what type of exposure is wanted in the portfolio, and digging down a level in the peer group analysis, can help hone the comparison and pick the more appropriate manager.

Fundamental differences on how the product is run – This one is a little more difficult to pin down. It is primarily driven by how a manager/fund approaches the asset class. As an example, high-yield bond and emerging market debt are two fairly specific asset classes, but have a wide variety of return differentiation between the managers. In high-yield, this return differentiation is often caused by a focus on higher quality versus lower quality issues within the high-yield space. Time-period-specific returns will vary greatly, but the higher-quality manager tends to provide better risk mitigation in a difficult market and will likely lag the lower-quality manager in a favorable market. In emerging market debt, the wide differentiation of returns is often driven by the decision to hedge the local currencies. A fund/manager who decides not to hedge back to the U.S. dollar will likely do well when the dollar is weak and may face a headwind when the dollar is strong. The manager is not taking a stance on dollar strength or weakness, but rather making a decision on how to manage the product. Clearly understanding the varying product approaches and considering them when completing peer analysis can be beneficial.

So, next time you are evaluating a fund/manager, don’t believe everything you think. Many times, there are underlying aspects of asset classes, philosophies, categorization and other influences that cloud our insight into making sound decisions. Understanding these obstacles is the first step in overcoming them and choosing more appropriate options for our clients.

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